have a substantial number of cross holdings in other firms will often report in-
creases or decreases to earnings reflecting these holdings. The effect on earn-
ings will vary depending on how the holding is categorized. Often, you will see
them categorized into one of the following:- A minority, passive holding, where only the dividends received from the
holding are recorded in income. - A minority, active interest, where the portion of the net income (or loss) from
the subsidiary is shown in the income statement as an adjustment to net in-
come (but not to operating income). - A majority, active interest, where the income statements are consolidated and
the entire operating income of the subsidiary (or holding) are shown as part of
the operating income of the firm. In such cases, the net income is usually ad-
justed for the portion of the subsidiary owned by others (minority interests).
The safest route to take with the first two types of holdings is to ignore the in-
come shown from the subsidiary when valuing a firm, to value the subsidiary
separately and to add it on to the value obtained for the parent. As a simple ex-
ample, consider a firm (Holding Inc.) that generates $100 million in after-tax
cash flows from its operating assets and assume that these cash flows will grow
at 5% a year forever. In addition, assume that the firm owns 10% of another
firm (Subsidiary Inc.) with after-tax cash flows of $50 million growing at 4% a
year forever. Finally, assume that the cost of capital for both firms is 10%. The
firm value for Holding Inc. can be estimated as follows.
When earnings are consolidated, you can value the combined firm with the consoli-
dated income statement and then subtract out the value of the minority holdings. To
do this, though, you have to assume that the two firms are in the same business and
are of equivalent risk since the same cost of capital will be applied to both firm’s cash
flows. Alternatively, you can strip the entire operating income of the subsidiary from
the consolidated operating income and follow the process laid out above to value the
holding.
(iv) Warning Signs in Earnings Reports. The most troubling thing about earnings re-
ports is that we are often blindsided not by the items that get reported (such as ex-
traordinary charges) but by the items that are hidden in other categories. The follow-
ing checklist should be reviewed regarding any earnings report to gauge the
possibility of such shocks:
- Is earnings growth outstripping revenue growth by a large magnitude year after
year? This may well be a sign of increased efficiency, but when the differences
$ 2,187 millionValue of Holding company's share of Subsidiary Inc$ 2,1000.10 18672Value of operating assets of Subsidiary Inc. 50 a1.04
0.100.04b$ 867 millionValue of operating assets of Holding Inc. 100 a1.05
0.100.05b$ 2,100 million9 • 34 VALUATION IN EMERGING MARKETS